(Article from Registered Funds Regulatory Update, April 2022)
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In a first-of-its-kind enforcement action, the SEC announced settled charges against BlockFi Lending LLC for failing to register the offers and sales of its retail crypto lending product and violating the registration provisions of the Investment Company Act. The SEC further found that BlockFi made materially false and misleading statements concerning the level of risk in its loan portfolio. As part of the settlement and parallel actions by state securities regulators, BlockFi agreed to pay $100 million in penalties and fines, as well as to cease offering its interest-bearing BlockFi Interest Accounts (“BIAs”) to new U.S. customers and accepting new investments from current U.S. investors, and bring its business within the provisions of the Investment Company Act within 60 days. BlockFi also will be required to register its new product, BlockFi Yield, in accordance with SEC rules for the offering of securities. The settlement is the first major enforcement action in the crypto lending sector for SEC Chair Gary Gensler and the case—particularly the allegations that investors were deceived as to the safety of their investments—will likely become an important talking point in the SEC’s intensifying crackdown on the crypto sector.
BlockFi, a cryptocurrency lending and trading platform, offered and sold BIAs to investors who deposited cryptocurrency in exchange for variable monthly interest payments. BlockFi generated the interest paid to these investors by deploying assets in various ways, including loaning crypto assets to institutional and corporate borrowers, and investing in equities and futures. Account holders received a variable rate of interest tied to the yield on BlockFi’s investment—which recently was advertised as “up to 9.25% APY.” The company warned that neither rates nor deposits are guaranteed, and that BIA losses are not insured by the Federal Deposit Insurance Corp. or the Securities Investor Protection Corp.
The Order concludes that BlockFi violated the securities laws in three respects:
First, while BlockFi previously took the position that a BIA is not a security and, therefore, should not be regulated as a security, the SEC concluded the opposite—that the BIAs are securities and should be registered under the Securities Act when publicly offered because they fit the definition of an “investment contract” under the test established by SEC v. W.J. Howey Co. Under the so-called “Howey test,” an investment contract is “an investment of money in a common enterprise with profits to come” primarily from the efforts of others. Further, the SEC concluded that the BIAs are securities because they fit the definition of “notes” under the four-part “family resemblance” analysis established by Reves v. Ernst & Young. Under Reves, a note is presumed to be a security unless it falls into certain judicially created categories of financial instruments that are not securities, or if the note in question bears a “family resemblance” to notes in those categories.
Second, the SEC concluded that BlockFi operated for more than 18 months as an unregistered investment company in violation of the Investment Company Act because it issued securities, and held more than 40% of its total assets (excluding cash) in investment securities, including loans of crypto assets to institutional borrowers.
Third, according to the Order, BlockFi misrepresented on its website that its institutional loans were “typically” over-collateralized, when in fact, most institutional loans were not. Accordingly, the company is alleged to have materially overstated the degree to which it secured protection from defaults by institutional borrowers from collateral.
While the SEC continues to file enforcement actions targeted at specific digital asset securities, it now appears to have turned a sharp focus towards crypto exchanges and lending products. The $100 million in penalties and fines is among the largest regulators have imposed on a cryptocurrency firm.
In the Matter of BlockFi Lending LLC, SEC Admin. Proc. File No. 3-20700 (Feb. 14, 2022), available at: https://www.sec.gov/litigation/admin/2022/33-11029.pdf.